February 2, 2019
Welcome to Part Two of Financial Independence Backup Plans!
Last week, we discussed the many ways we can reduce spending, should our dividend income take a drastic hit in retirement. And we found that even for a relatively frugal household like ours, we can still adjust our expenses considerably.
But if you remember, that still left us with a cashflow gap of $6,000 per year.
Luckily we were just getting started!
There’s plenty more we can do to plug this, and greater shortfalls, which is what today’s post is all about. So let’s get into it…
It’s almost so obvious, there’s not much to say about it. But keeping a chunk of cash on hand in case our income falls (or unexpected expenses come up) is something we should all do – retired or not.
Here’s how it’d work…
Using the figures we’ve established so far – our income falls 40%, we adjust our spending, but there’s still a $6,000 per year gap. Let’s call it $10,000.
If we have $50,000 as a cash buffer, this would top up our income for 5 full years.
But this assumes dividends do not recover at all during that time. The overwhelmingly likely scenario is dividends steadily recover after a large initial drop.
So this cash buffer is likely to last longer than 5 years. Probably more like 7-10 years.
And if we keep $100,000 cash (which may be something close to 10% of the portfolio), it’ll last twice as long. Then our income could be topped up for 10 years with no recovery in dividends. Or perhaps 15-20 years with a steady recovery!
By that time, the economy will be back on track and company profits growing once more – in line with the relentless long term trend.
Now I know there’s inflation and other variables we could go into. Forgive me for wanting to keep it simple!
The point is, with flexible spending, a decent cash buffer is likely to last a long time. How much you want to have is up to you. But we’ll probably opt for a smaller lump of cash (say $50k) and be more flexible. More on this later.
Of course they are. This is the future we’re talking about.
I don’t care who you are or how sophisticated your ‘modelling’ is, you simply can’t know the future. Some basic maths and common sense are far more useful in my view.
So far, we can see a combination of flexible spending and a cash buffer goes a very, very long way to seeing through some pretty dark times.
And the less flexible you are, the more cash you’ll need to keep on hand. This means more saving and a longer road to Financial Independence.
But remember, keeping more in cash is a drag on your long term investment returns.
If you have an extra $50k sitting around earning 2% interest, instead of 8% return in shares – you’re missing out on an extra $3k per annum. And that compounds to become a greater number every year.
So a lack of flexibility is costing you short term freedom as well as long term wealth!
Not to say you shouldn’t have a decent buffer, just something to keep in mind.
Uh-oh, more of that flexibility nonsense!
The fact is, most of us have at least 1 spare bedroom that we do nothing with.
Maybe it’s an office we don’t really use. Maybe it’s full of stuff we’ve simply collected over the years. A youngster’s old room who’s now grown up, moved out and unlikely to ever come back. Or it could be that extra guest room that is rarely ever used.
We’re a perfect example. Sure, we do have the odd guest staying every now and then. But we rent a 4 bedroom house, and most of the time, only 1 of those bedrooms gets used!
A while back now, I wrote a post about setting up an income stream from your unused space. We’re no longer in this situation, but it’s always an option in the future.
And keep in mind, in a recession, the number of people looking to reduce housing costs by sharing is likely to grow substantially.
This room value calculator by Flatmates.com.au suggests one of our spare rooms would earn roughly $8,500 per year.
Now I don’t know about you, but that’s a ton of cash for us!
In fact, when you think about it, this creates the same amount of income as about $200,000 worth of shares!
So it would be silly to just wave it away as a silly idea. That alone would go a huge way to topping up our dividend income in a recession.
Instead of cutting spending by $12,000 as stated in Part One, we could keep most of the luxury we currently enjoy and simply have a housemate for a while.
If you own your house, there are of course tax consequences to consider. But it’s simply another option to choose from, for generating some extra cashflow.
Which brings us to the next, perhaps the most dreaded option…
We’ve covered a number of ways to plug this imaginary income gap we’ve created. And I thought I’d leave working as the last option.
Well, this is an early retirement blog!
Therefore, I’m going to assume that maximum freedom is a pretty high priority for readers. So going back to work is perhaps not what jumps out as the first solution!
Nevertheless, turning on this income tap for a while is still a very viable option.
Let’s take a look at our own scenario to see how this would work…
We’re a relatively unskilled couple of early retirees. The only real qualification between us is a forklift ticket (which I think has now expired!).
But given Australia’s generous wages compared with other countries, basically everyone can earn at least $20 per hour, doing all sorts of unskilled work. (We’ll ignore the fact that we both earned $30+ per hour, in our relatively unskilled jobs.)
So let’s see how much work it takes to top up our dividend income.
First, we’ll assume the earlier figure of a $6,000 shortfall in our retirement cashflow, after optimising our expenses.
To generate $6,000 from working, we’d need to make around $120 per week. Or about 6 hours work per week.
And that’s between us. So 3 hours each. Or 6 hours if only one of us can find work.
In fact, to make $18,000 per year and cover the entire 40% collapse in our dividend income (if we didn’t want to spend less), we’d need to work 18 hours per week between us to plug the hole. Or 9 hours each per week.
Roughly one day per week each, or two half-days.
This also ignores every single option we’ve discussed so far. So if we weren’t the slightest bit flexible in spending or living arrangements, and kept zero cash on hand, this is what it would come to.
Hardly a disaster!
And there’d be no tax because we’re still under the tax free threshold. In any case, given the tax efficiency of Aussie dividends, we could use excess franking credits to offset any tax owing on work income.
Now, obviously there are less jobs available during a recession. But part-time work is much more likely to be available than full-time work during those times.
After shedding workers, companies are generally slow to re-hire full-time employees. But will happily take on part-time workers to fill gaps, as demand slowly picks up and the economy finds an equilibrium.
And that’s exactly what work we’d be looking for.
The unemployment rate will climb from roughly 5% today, possibly up to 10% during a recession.
That sounds pretty bad. And it is. But remember, this also means that 90% of people who want employment, still have it!
Now, you can argue that ‘underemployment’ is higher than that (people with a job but want more hours), and it will be. But that doesn’t concern us. A small amount of part-time employment is all we need.
In reality, all you’d need to do is keep a small cash buffer and adjust spending until you did find some part time work (if this is your preferred backup plan).
As always, people will find reasons why this option isn’t possible. So if you don’t like your chances of finding ANY employment for a number of years, then simply focus on the other backup plans!
It’s been put to me that someone on even lower spending than us (labelled Lean FIRE) would have real trouble plugging the gap if their investment income dropped after leaving work.
Say a couple has paid off their house and they’re living on $25,000 per year, which covers their expenses.
If this income drops by 40%, they’ll now only earn $15,000 from their investments. So there’s a gap of $10,000.
What can they do?
Well, considering our own non-housing expenses are also around $25,000 per year, there’s likely still a surprising amount of room to trim spending. Let’s say they can come up with just $3,000 per year in savings.
Now the gap is $7,000.
I’d certainly hope they had a stash of cash in the bank for times like this – perhaps around $50,000 or so. This would top up their income for a good 5-10 years.
Then of course there’s the option of part-time work. And again, to make $7,000 to cover the gap (completely ignoring the cash buffer), they’d only need to make around $130 per week, or around 6 hours between them.
And finally, they could choose to get a housemate, while acknowledging tax considerations. Depending how the numbers stack up, our couple could also move to a lower cost rental, while leasing their own place out.
And as a couple of readers have pointed out, they could even go travelling to some low-cost countries for an extended period of time. That option is open to all of us, mind you. (I didn’t put this in Part One as it’s not part of our own plans so could be labelled as unrealistic and “easy for you to say.”)
Because this gap is a smaller dollar amount to fill, our couple’s income is more easily topped up with cash, part-time work, or housing arrangements. So the Lean FIRE crowd may actually, and counter-intuitively, have it easier than the rest of us!
If it’s not already apparent, we do things a little differently around here.
Instead of focusing on the market value of our portfolio, we’re laser-focused on the income from our investments.
So rather than the typical ‘withdrawal’ strategy of selling down shares in retirement, we’re using a cashflow approach. Therefore, instead of being reliant on market prices, we’re choosing to rely on company dividends.
To me, this is a simpler way to invest. And for better or worse, it’s the approach I feel most comfortable with.
At the end of the day, you can create the most optimal portfolio in the world, but it’s largely useless if the investor doesn’t feel comfortable with that strategy.
Anyway, our cashflow approach means simulating a crash type scenario is very different. Every example I’ve seen focuses on how long a portfolio takes to get back to its peak value after a crash, and testing how long different backup plans will work from there.
For us, that makes zero sense. You’ll see why in the next two sections.
Because of our focus on income, dividend focused vehicles like LICs are a large part of our portfolio.
Now, they’re far from perfect, but in times of crisis, the income from these investments is much more dependable than many other options.
As I’ve mentioned before, and for those unaware…
The company structure allows LICs to retain profits by paying out less than 100% of earnings. These retained profits are reinvested in the portfolio, and also means excess franking credits which can be used in future years.
When the economy runs into trouble and many companies cut their dividends, the income from these LICs naturally falls. But because of the excess franking generated in previous years and the small amount of cash they hold, LICs can pay above 100% of earnings (if deemed prudent) until dividends from the portfolio recover.
In short, it means more reliable dividends through the cycle and less vicious cuts to dividends in scary times.
Like during the GFC, when ASX dividends were down around 25%. Some old LICs cut dividends by 15% or less. And some not at all.
Now I know some argue this is meaningless, as it’s just a timing factor. But the fact is, when we’re living through scary times, and living off our portfolio, this can make a huge difference psychologically.
You might see where I’m going with this.
Using our imaginary recession scenario that we’re playing out here, the consequences vary for different investors.
— A capital growth focused investor may be looking at a 50%-60% decline in the value of their holdings.
— An income focused investor may be looking at a 25%-40% decline in their dividend income.
— And an investor in LICs may be looking at a 10%-25% decline in their dividend income.
So rather than focusing on the 50%-60% decline in their portfolio, the income investor is comforted in the fact that their cashflow (which is their primary focus) has only declined by half of that amount – perhaps even less.
Because we’re living off the income, in my eyes, the real risk is our dividends falling. Not our portfolio value falling, as most people see it.
This isn’t to say the strategy is better. It’s to say, think of the emotional impact this has on each investor.
The lessened volatility of income investing and to a smaller extent LICs, may be the difference between holding on and riding through the storm, and freaking out and doing something stupid.
I don’t know about you, but given market volatility, when the shit hits the fan, I want to be able to focus on something more dependable. Like the income paid by the underlying businesses, rather than what panicked investors are trading those shares for.
While volatility is very real for every share investor, I’m much happier focusing on the far lower volatility of dividends. Not because my shares won’t plummet in value. They will! But because my strategy is based on income, not market prices.
So the price movements, day to day, year to year, don’t really matter. Instead, I can simply do my best to tune out the noise, like I do anyway, and focus on the cashflow from the portfolio.
Because old LICs make up a decent chunk of our portfolio, our income is unlikely to fall by the 40% disaster scenario I’m painting. I’m happy to use this as a base case, but just pointing this out as an additional check in the column of “why we’ll manage just fine.”
So far we’ve covered lots of possible financial independence backup plans.
It’s a pretty scary scenario to think about – a 40% cut to our investment income! But here’s why I’m not concerned…
— 1. We have a hefty portion of our portfolio in LICs, which are likely to cut dividends much less than 40%.
— 2. We’re flexible with our spending. Last week I covered the many ways we can reduce costs by $12,000 per year, which only left a gap of $6,000. Even then, I think we could close that gap entirely through optimising spending.
— 3. We can get a housemate to share housing costs, which would create an extra $8,500 per year.
— 4. We’ll keep a cash buffer of around $50,000, which will top up our dividend income for a number of years.
— 5. We can earn some part-time income. Indeed, we’re both already doing this, out of interest rather than necessity. And this bonus income – mostly from Mrs Strong Money – is higher than half our yearly spending.
— 6. Just one or two of these options is likely to fix the problem entirely. But because we’re willing to utilise all of them, any shortfall in our retirement income can be covered in a number of ways. We can mix and match any combination of the above.
As I see it, each of these things is like a layer of insulation. So even in this very ugly scenario I’ve painted, our income and expenses are never likely to be far apart.
These factors and our personal flexibility combine to make our our financial position much stronger than money alone.
I did too. Think again!
For whatever reason, I was convinced I’d be one of those people who’d be perfectly happy lounging around after reaching my ultimate goal.
But the human mind doesn’t work like that. In case you missed it, here’s what I learned after One Year of Freedom.
After 6 months or so, you’ll have so much productive energy and need an outlet for it. So you begin pursuing new ideas and working on things you’re interested in – many of which result in earning income. Then you go on to realise you probably didn’t need that much money to ‘retire’ in the first place!
But don’t tell anyone. Because then you’re outed as a fraud for ‘working’!
The strange reality is that most people who reach Financial Independence go on to earn income after retiring. Humans thrive on being productive. We can’t help ourselves!
I didn’t really believe that until I experienced it. 5 years ago, if you said I’d end up doing something creative, like writing, and even earning a little bit of income from it, I’d ask what you’ve been smoking!
The point is, it’s really hard to imagine what we’ll do when we’re still working and on the path to FI. But just accept that you’ll be full of energy and looking for somewhere to use it!
By far, the most powerful weapon against the unexpected is our own character.
We need to be adaptable. We need to be flexible. And we need to stay calm and focused on solving whatever problems we’re faced with.
Obviously, this is our approach and what I think is a common sense way of dealing with things. But your own backup plan can include whatever you like.
For those who are not so keen on all of this flexibility stuff, consider this…
— The less willing you are to adjust your spending, the more money you need.
— The more cash buffer you want to protect you from these scenarios, the more money you need.
— The less willing you are to get a housemate or optimise your housing costs, the more money you need.
— The less open you are to working part-time, the more money you need.
It’s perfectly okay to feel this way. But realise, this lack of flexibility means your journey to Financial Independence is likely to be a longer one!
Your rigidity is going to cost you many years of freedom and a calmer state of mind.
Those who want a 100% success rate from their portfolio and are looking for a bulletproof plan, will always be worried about not having enough. Because those people generally have a fearful mindset.
Let’s see how much flexibility is worth as a character trait.
If you are open to cutting your spending by $8,000 in a recession scenario, this is equivalent to having an extra $200,000 of investments.
And if you can manage just $4,000 per year, then you’re $100,000 better off than the no-flex household.
Because the rigid folks will need that much extra before they can retire, because of their unwillingness to reduce spending.
So if you’re open to cutting spending by $8,000, plus earning an extra $8,000 through part-time work, you need $400,000 less in investments than the no-flex folks.
Now can you see how incredibly valuable this one character trait is?
It’s worth an absolute fortune and many years of your life!
Not only that, but comes with a stronger mindset of a person who is relaxed about this stuff, knowing you’ll adjust as needed and make it through just fine.
The more cushion and ‘safety’ you want in retirement, the more that costs you in foregone freedom.
For us, we chose to retire sooner with less, because it just made sense from so many angles.
And despite all this talk of flexibility, there’s no guarantee you’ll even have to use it!
Because if you retire early, there’s a very good chance you’ll end up doing something productive that earns income. That’s just what happens when you start living a self-directed life.
On the other hand, there is a definite guarantee that you’ll need to work longer to build the extra savings needed, to avoid having to do any of this stuff.
I’ll take the guaranteed freedom sooner, any day!
Think of it as a scale. Less flexibility = more money needed. More flexibility = less money needed.
Or, the more personal strength you have, measured in adaptability, the less financial strength you need.
There’s no question, thinking of a nasty Aussie recession in retirement is a little scary.
In these situations, our mindset and personal traits are far more valuable than we think.
But at the end of the day, everyone gets to decide for themselves the amount of cushion they want and what level of flexibility they’re open to.
As I’ve shown using our own finances, any cashflow gap can be plugged in a huge number of ways: reduced spending, a cash buffer, part-time work, getting a housemate etc.
So for those of us willing to use the backup plans available to us, adapt to new conditions and remain flexible, there’s little to worry about.
Personally, the fact that we can cover any drastic dividend cuts many times over, allows us to sleep well at night, move forward with confidence and enjoy our early retirement, worry free!
And ultimately, that’s what it’s all about!
What’s your financial independence backup plans? Share with me in the comments…